Are REITs a Distinct Asset Class?
Thursday, 29 June, 2017

Real estate investment trusts (REITs) are often considered to be a distinct asset class. But, do REITs deserve this designation? While exact definitions for asset class may vary, a number of statistical methods can provide strong evidence either for or against the suitability of the designation. The authors step back from the established real estate and REITs literature and answer this broader question. Beginning with a set of asset class criteria, the authors then utilize a variety of statistical methods from the literature and factor-based asset pricing to evaluate REITs for their candidacy as a distinct asset class. REITs fail to satisfy almost all of the relevant criteria which leads the authors to conclude that REITs, in fact, are not a distinct asset class but do deserve a market capitalization weighted allocation in a diversified investment portfolio.

Notable quotations from the academic research paper:

"Many investors think of real estate investment trusts (REITs) as a distinct asset class because, in aggregate, they have historically had relatively low correlation with both stock and bond markets. However, this is a far too simplistic definition for what defines a distinct asset class. Many individual stocks have low correlation with the overall stock and bond markets, yet no one would (hopefully) consider a single stock, or a small handful of stocks, to be an asset class. For individual equities, a better definition would be a well diversied portfolio of securities which has historically demonstrated statistically significant excess return relative to what is explained by a generally accepted factor model like the Carhart [1997] four-factor model. For example, early research on the size and value premiums argued that these two types of equity securities are distinct equity asset classes because their excess returns are not fully accounted for by CAPM.

On a relative basis, public REIT equities are a young investment vehicle. The REIT Act title law of 1960 allowed the creation of REITs and accordingly, the ability for investors to gain access to diversified real estate portfolios. The first REIT was formed shortly thereafter and the first public REIT debuted in 1965. Early research into public real estate investment, such as Webb and Rubens [1987], tends to use appraisal-based individual property data and suggests that real estate provides diversication benefits for traditional stock and bond portfolios. Following the growth of the industry and accumulation of sufficient returns histories, REIT indexes debuted. Subsequent studies often used REIT indexes, tending to confirm earlier findings concerning diversification benefits and suggesting sizable portfolio allocations.

We establish a pragmatic list of criteria for consideration as an asset class and then use an array of techniques to evaluate REITs as such. While REITs do indeed exhibit relatively low correlation with traditional equity and fixed income, a deeper dive into their returns reveal shortfalls in their qualifications for asset class distinction. Four- and six-factor regression analyses reveal no statistically reliable alpha generation in REIT returns and coefficient estimates point to REITs being well explained by traditional risk factors. Taking direction from the regression results and attempting a long-only replication of REIT returns with small-value and equities and long-term corporate bonds produces a portfolio that comoves well with REIT returns and exhibits historically superior return and risk characteristics. Utilizing tests of mean-variance spanning, we also examine the diversification properties of REITs on a statistically inferred basis. These tests suggest that REITs do not reliably improve the mean-variance frontier when added to a benchmark portfolio of traditional stocks and bonds. These results, and the associated failure to satisfy our asset class criteria, lead us to conclude that REITs are not a distinct asset class.

In conclusion, we want to make clear that we are not suggesting that REITs deserve no allocation in an investment portfolio. Nor are we suggesting that any results previously brought forth in the literature are spurious or incorrect. The results of this study lead us only to suggest that REITs, as an equity security with only marginal diversication benefits, should not receive a weighting in investor portfolios that significantly deviates from market capitalization based weights. The Dow Jones U.S. Select REIT Index represents a non-trivial approximately 2.5 percent of the Russell 3000 Index, as of early 2017, on a market capitalization basis, which we would argue is a valid starting point for a REITs allocation in a diversified portfolio."